FxWirePro: A Run Through on GBPAUD – EURGBP Vol Spread

The currency differentiation and short correlation were laid out as one of the core vol alpha themes for H2 in the Mid-Year Outlook. One class of trades that were identified in there was selling GBP vs. commodity FX correlation on the view that GBP’s idiosyncratic political dynamics would lead to low / no correlation with other cyclically sensitive FX. 

One such corr short that could be considered at current levels is EURGBP vs EURAUD: 3M implied corr is 26% vs. 2-wk realized corr -4%, 1-mo 16% and 3-mo 7% (refer 1st chart). Backtest in the 2nd chart shows favorable historical performance over the past 3-yrs since the Brexit vote. 

A pushback is that if the ECB pivots towards re-starting QE later this year the EUR could fall against everything in sight and lift all EUR-x vs. EUR-y realized correlations, as it happened when EURUSD fell from 1.40 to 1.05 during the ECB QE of 2014-16. Two ways of guarding against this: 

a) limit expiry to pre-September ECB, when a 10bp rate cut is expected and when a potential QE announcement might come; and/or 

b) hold appropriately sized EURUSD put spreads against a short corr. swap, but sizing is a non-trivial problem. With 2M EURGBP – EURAUD corr swap @24/35 indicative, we think vol spread is an attractive alternative to consider: 

Hence, 2M GBPAUD – EURGBP vol spread recommended @0.95/1.45 indicative. Courtesy: JPM